What Is Earnings Before Interest and Taxes (EBIT)?
Earnings before interest and taxes is an indicator of a company's profitability. One can calculate it as revenue minus expenses, excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes.
The Formula for Earnings Before Interest and Taxes (EBIT) Is
EBIT (Earnings Before Interest and Taxes)
How to Calculate Earnings Before Interest and Taxes (EBIT)
You calculate EBIT by taking a company's cost of manufacturing including raw materials, as well as the company's total operating expenses, which includes employee wages and subtract those figures from revenue. The steps are outlined below:
- Take revenue or sales from the top of the income statement.
- Subtract the cost of goods sold from revenue or sales, which gives you gross profit.
- Subtract the operating expenses from the gross profit figure to achieve EBIT.
What Do Earnings Before Interest and Taxes (EBIT) Tell You?
Earnings before and taxes measures the profit a company generates from its operations, making it synonymous with operating profit. By ignoring taxes and interest expense, EBIT focuses solely on a company's ability to generate earnings from operations, ignoring variables such as the tax burden and capital structure. EBIT is an especially useful metric because it helps to identify a company's ability to generate enough earnings to be profitable, pay down debt, and fund ongoing operations.
EBIT and Taxes
EBIT is also helpful to investors who are comparing multiple companies with different tax situations. For example, let's say an investor is thinking of buying stock in a company, EBIT can help to identify the operating profit of the company without taxes being factored into the analysis. If the company recently received a tax break or there was a cut in corporate taxes in the U.S., the company's net income or profit would increase.
However, EBIT removes the benefits from the tax cut out of the analysis. EBIT is helpful when investors are comparing two companies in the same industry but with different tax rates.
EBIT and Debt
EBIT is helpful in analyzing companies that are in capital intensive industries meaning the companies have a significant amount of fixed assets on their balance sheets. Fixed assets are physical property, plant, and equipment and are typically financed by debt. For example, companies in the oil and gas industry are capital intensive because they have to finance their drilling equipment and oil rigs.
As a result, capital intensive industries have high-interest expenses due to the large amount of debt on their balance sheets. However, the debt, if managed properly, is necessary to the long-term growth of companies in the industry.
Companies in capital intensive industries might have more or less debt when compared to each other. As a result, the companies would have more or less interest expenses when compared to each other. EBIT helps investors to analyze the companies operating performance and earnings potential while stripping out debt and the resulting interest expense.
- EBIT (earnings before interest and taxes) is a company's net income before income tax expense and interest expenses have been deducted.
- EBIT is used to analyze the performance of a company's core operations without the costs of the capital structure and tax expenses impacting profit.
- EBIT is also known as operating income since they both exclude interest expenses and taxes from their calculations. However, there are cases when operating income can differ from EBIT.
Examples of How to Use Earnings Before Interest and Taxes (EBIT)
Let's say you're thinking of investing in a company that manufactures machine parts. At the end of the company's fiscal year last year they had the following financial information on their income statement:
- revenue: $10,000,000
- cost of goods sold: $3,000,000
- gross profit: $7,000,000
The company's gross profit would equal $7,000,000 or the profit before overhead expenses are subtracted. The company had the following overhead expenses, which is listed as sales, general and administrative expenses:
- SG&A: $2,000,000
The operating income or EBIT for the company would be:
- EBIT: $5,000,000 or ($10,000,000 - $3,000,000 - $2,000,000).
The Various Ways EBIT Is Used
There are different ways to go about calculating EBIT, which is not a GAAP metric and therefore not usually included in financial statements. Always begin with total revenue or total sales and subtract operating expenses, including the cost of goods sold. You may take out one-time or extraordinary items, such as the revenue from the sale of an asset or the cost of a lawsuit, as these do not relate to the business' core operations, but these may also be included.
Also, if a company has non-operating income, such as income from investments, this may be (but does not have to be) included. In that case, EBIT is distinct from operating income, which, as the name implies, does not include non-operating income.
Often, companies include interest income in EBIT, but some may exclude it depending on its source. If the company extends credit to its customers as an integral part of its business, then this interest income is a component of operating income, and a company will always include it. If, on the other hand, the interest income derives from bond investments, or charging fees to customers that pay their bills late, it may be excluded. As with the other adjustments mentioned, this one is up to the investor's discretion and should be applied consistently to all companies being compared.
Real World Example of How to Use EBIT
As an example, we'll use Procter & Gamble Co's income statement from the year ending June 30, 2016 (all figures in millions of USD):
|Cost of products sold||32,909|
|Selling, general and administrative expense||18,949|
|Other non-operating income, net||325|
|Earnings from continuing operations before income taxes||13,369|
|Income taxes on continuing operations||3,342|
|Net earnings (loss) from discontinued operations||577|
|Less: net earnings attributable to non-controlling interests||96|
|Net earnings attributable to Procter & Gamble||10,508|
To calculate EBIT, we subtract the cost of goods sold and the selling, general and administrative expense from the net sales. However, P&G had other types of income that can be included in the EBIT calculation. P&G had non-operating income and interest income, and in this case, we calculate EBIT as follows:
- EBIT = net sales - COGS - SGA expenses + non-operating Income + interest income
- EBIT = $65,299 - $32,909 - $18,949 + $325 + $182 = $13,948
For the fiscal year ended 2015, P&G had a Venezuelan charge. Whether to include the Venezuela charge raises questions. As mentioned above, a company can exclude one-time expenses. In this case, a note in the 2015 earnings release explained that the company was continuing to operate in the country through subsidiaries. Due to capital controls in effect at the time, P&G was taking a one-time hit to remove Venezuelan assets and liabilities from its balance sheet.
Similarly, one can make an argument for excluding interest income and other non-operating income from the equation. These considerations are to some extent subjective, but one should apply consistent criteria to all companies being compared. For some companies, the amount of interest income they report might be negligible, and you can omit it. However, other companies like banks, generate a substantial amount in interest income from investments they hold in bonds or debt instruments.
Another way to calculate P&G's fiscal 2015 EBIT is to work from the bottom up, beginning with the net earnings. We ignore non-controlling interests, as we're only concerned with the company's operations, and subtract the net earnings from discontinued operations for much the same reason. We then add income taxes and interest expense back in to obtain the same EBIT we did via the top-down method:
- EBIT = Net Earnings - Net Earnings from Discontinued Operations + Income Taxes + Interest Expense
- Therefore, EBIT = $10,604 - $577 + $3,342 + $579 = $13,948
The Difference Between EBIT and EBITDA
EBIT is a company's operating profit without interest expense and taxes. However, EBITDA or (earnings before interest, taxes, depreciation, and amortization) takes EBIT and strips out depreciation, and amortization expenses when calculating profitability. Like EBIT, EBITDA also excludes taxes and interest expenses on debt.
For companies with a significant amount of fixed assets, they can depreciate the expense of purchasing those assets over their useful life. In other words, depreciation allows a company to spread the cost of an asset out over many years or the life the asset. Depreciation saves a company from recording the cost of the asset in the year the asset was purchased. As a result, depreciation expense reduces profitability.
For company's with a significant amount of fixed assets, depreciation expense can impact net income or the bottom line. EBITDA measures a company's profits by removing depreciation. As a result, EBITDA helps to drill down to the profitability of a company's operational performance. EBIT and EBITDA each have their merits and uses in financial analysis.
Limitations of Earnings Before Interest and Taxes (EBIT)
As stated earlier, depreciation is included in the EBIT calculation and can lead to varying results when comparing companies in different industries. If an investor is comparing a company with a significant amount of fixed assets to a company that has few fixed assets, the depreciation expense would hurt the company with the fixed assets since the expense reduces net income or profit.
Also, companies with a large amount of debt will likely have a high amount of interest expense. EBIT removes the interest expense and thus inflates a company's earnings potential, particularly if the company had a lot of debt. Not including debt in the analysis can problematic if the company had increased its debt due to a lack of cash flow or poor sales performance. It's also important to consider that in a rising rate environment, interest expense will rise for companies that carry debt on their balance sheet and must be considered when analyzing a company's financials.
For more on EBIT, read about how are EBIT and operating income different.